Wheel Industries: Capital Budgeting and Financial Management Analysis

This report offers a comprehensive analysis of capital budgeting techniques applied to Wheel Industries. It begins with an introduction to capital budgeting and then delves into specific requirements, including the calculation of the cost of equity, merits and demerits of equity financing, after-tax cost of debt and its advantages and disadvantages. The report then calculates the Weighted Average Cost of Capital (WACC) and uses it for investment analysis. It calculates the Net Present Value (NPV) and Internal Rate of Return (IRR) to evaluate the profitability of a project. The report also compares two investment projects, B and C, using NPV to determine which is more financially viable. The conclusion emphasizes the importance of critically evaluating investment opportunities using capital budgeting techniques, with a recommendation for project C based on its higher NPV. References from academic sources are included to support the analysis.

RUNNING HEAD: FINANCIAL MANAGEMENT
Capital Budgeting Techniques

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Contents
Introduction............................................................................................................... 3
Analysis................................................................................................................... 3
Requirement A........................................................................................................ 3
Requirement B........................................................................................................ 4
Requirement C........................................................................................................ 5
Requirement D........................................................................................................ 5
Requirement E........................................................................................................ 6
Requirement F........................................................................................................ 6
Requirement G........................................................................................................ 7
Requirement H........................................................................................................ 8
Conclusion and Recommendation.................................................................................... 9
References.............................................................................................................. 10

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Introduction
The report provides a detailed knowledge about the application of different capital budgeting
techniques, used for evaluating projects. It involves the evaluation of long term investment
projects of Wheel industries, followed by the conclusion and recommendation.
Analysis
Requirement A
Initial Investment ($ million) 1.5
Additional revenue before tax per year ($
million) 1.2
Additional annual cost ($) 600000
Tax rate 35%
Salvage Value 0
Depreciation expenses per year 500000
Life of the project 3 years
Calculation of new cost of equity
Dividend paid per share ($) 2.5
Growth rate 6%
Market price per share ($) 50
Flotation cost 10%
Dividend paid per share next year ($) 2.65
Ke (cost of equity) 11.89%

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Merits of equity financing
 The business will earn the return and the investors can only realize their investment, if
the business is performing well.
 The capital can be used for business operations rather than utilizing it for debt
financing (Porter & Norton, 2012).
 It helps in the growth and exploration of the organisation.
Demerits
 The method is costly and time consuming.
 More interference of the investors in the business (Business.qld.gov.au. 2017).
 Loss of power in making management decisions.
Requirement B
Marginal tax rate 35%
The pre-tax Cost of Debt 5%
After tax Cost of Debt 3.25%
Advantages of debt financing:
 It allows to make the debt payments in instalments.
 Firms can pay for new equipment, buildings and other assets required for growth of
the business.
 It does not require the surrendering of ownership or control of the business
(Business.qld.gov.au 2017).
Disadvantages:

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 Increase in the loan repayments along with the interests. Failed to do the same, can
result in the acquiring of the company’s assets by the bank for recovery.
 Over financing through debt can affect the future cash flows and growth.
 More debt makes the organization more risker from investor’s point of view
(Ramadani & Hisrich, 2016).
Requirement C
Cost after tax
Weight
s Weighted cost
Debt Kd 3.25% 0.3 0.98%
Common
Equity Ke 11.89% 0.7 8.32%
WACC 9.30%
WACC helps in reflecting the change in cost of debt to asset ratio and assist the management
in taking decisions regarding raising funds through debt or equity. In addition to this, by
applying weights to these cost, company can develop an optimum capital structure for the
business. It is also used as an investment tool by the analysts for evaluating and selecting
investment proposals (Baker & English, 2011).
Requirement D
Years 0 1 2 3
($) ($) ($) ($)
Initial Investment -1500000
Revenue 1200000 1200000 1200000

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Cost -600000 -600000 -600000
Depreciation -500000 -500000 -500000
Earnings before tax 100000 100000 100000
Tax provisions 35000 35000 35000
Earnings after tax 65000 65000 65000
Add: Depreciation 500000 500000 500000
Total cash flow after
tax -1500000 565000 565000 565000
Requirement E
Years
Cash
inflow pvf@6% Present values
0 -1500000 1 -1500000
1 565000 0.943396226 533018.8679
2 565000 0.88999644 502847.9886
3 565000 0.839619283 474384.8949
NPV 10251.75
NPV basically shows the profitability of a project. Generally, the proposals having high and
positive NPV are considered more desirable for investment purposes (Bierman & Smidt,
2012). The proposal of Wheel industries is economically acceptable because it has NPV of
$10251.75, which is positive and reflects that the project will generate profits in the future.
Requirement F
Years Cash inflow
0 -1500000

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1 565000
2 565000
3 565000
IRR 6.37%
This project is acceptable because the IRR is 6.37% which more than the cost of capital of
6%. There is no conflict because the all the cash flows are normal and the IRR is compare to
the cost of capital used for discounting the cash flows rather than with the WACC of the
business.
Requirement G
Calculation of annual after tax cash flow
Investment B
Probability After tax cash flow Expected value
0.25 20000 5000
0.50 32000 16000
0.25 40000 10000
Annual after tax cash flow ($) 31000
Investment C
Probability After tax cash flow Expected value
0.3 22000 6600
0.5 40000 20000
0.2 50000 10000
Annual after tax cash flow 36600

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($)
Expected annual after tax cash flow is calculated as follows:
Expected value = Sum of (probability*cash inflow after tax).
The same formula is applied for project C also. The annual cash flows for project B are
$31000 and of Proposal C are $36,600. There will be no conflict between the IRR and NPV
of the projects because both have same cash outflow and same years of life. Moreover, the
cash inflows are also normal.
Requirement H
Calculation of
NPV
Project B
Years
Cash
flow pvf@8% Present values
0 -120000 1 -120000
1 31000 0.926 28703.70
2 31000 0.857 26577.50
3 31000 0.794 24608.80
4 31000 0.735 22785.93
5 31000 0.681 21098.08
6 31000 0.630 19535.26
NPV 23309.27
Project C

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Years Cash flow pvf@8% Present values
0 -120000 1 -120000
1 36600 0.926 33888.89
2 36600 0.857 31378.60
3 36600 0.794 29054.26
4 36600 0.735 26902.09
5 36600 0.681 24909.35
6 36600 0.630 23064.21
NPV 49197.40
Although both the projects has positive NPV but the one having high value of NPV will be
accepted for the purpose of investment. Project C has NPV of $49,197.40 which is more than
the NPV of proposal B that is $23309.27. So, according to the rule of Net Present Value,
proposal C should be accepted (Fabozzi & Drake, 2009).
Conclusion and Recommendation
The above report concluded that, it is very necessary for the company to critically evaluate its
investment opportunities by using appropriate capital budgeting techniques. It can also been
seen from the report that Net Present Value method is the most suitable and used among the
various methods. Wheel Industries has chosen project C than project B, because of its high
NPV value.

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References
Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for
today's investment projects (Vol. 13). (pp. 341-359). New Jersey: John Wiley & Sons.
https://books.google.co.in/books?
id=OzZGDgAAQBAJ&printsec=frontcover&dq=Baker,+H.+K.,+%26+English,+P.
+(2011).+Capital+budgeting+valuation:+Financial+analysis+for+today
%27s+investment+projects+(Vol.+13).+New+Jersey:+John+Wiley+
%26+Sons.&hl=en&sa=X&ved=0ahUKEwi0weTirObZAhUTSI8KHW3SCYAQ6A
EILTAB#v=onepage&q&f=false
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of
investment projects. 9th ed. (pp. 53-54). New York: Routledge.
https://books.google.co.in/books?
id=1IPNXQmhzo8C&printsec=frontcover&dq=Bierman+Jr,+H.,+%26+Smidt,+S.
+(2012).+The+capital+budgeting+decision:
+economic+analysis+of+investment+projects.+9th+ed.+New+York:
+Routledge.&hl=en&sa=X&ved=0ahUKEwitxI35rObZAhWCNo8KHfrSAm0Q6AEI
LTAB#v=onepage&q&f=false